Advanced economies are facing the difficult challenge of implementing fiscal adjustment strategies without undermining a still fragile economic recovery. Fiscal adjustment is key to high private investment and long-term growth. It may also be key, at least in some countries, to avoiding disorderly financial market conditions, which would have a more immediate impact on growth, through effects on confidence and lending. But too much adjustment could also hamper growth, and this is not a trivial risk. How should fiscal strategies be designed to make them consistent with both short-term and long-term growth requirements?

We offer ten commandments to make this possible. Put simply, what advanced countries need is clarity of intent, an appropriate calibration of fiscal targets, and adequate structural reforms. With a little help from monetary policy, and from their (emerging market) friends.

Commandment I: You shall have a credible medium-term fiscal plan with a visible anchor (in terms of either an average pace of adjustment, or of a fiscal target to be achieved within four–five years).

There is no simple one-size-fits-all rule. Our current macroeconomic projections imply that an average improvement in the cyclically-adjusted primary balance of some 1 percentage point per year during the next four–five years would be consistent with gradually closing the output gap, given current expectations on private sector demand, and would stabilize the average debt ratio by the middle of this decade. Countries with higher deficits/debt should do more, others should do less. Such a pace of adjustment must be backed-up by fairly specific spending and revenue projections, and supported by structural reforms (see below).

For a few countries, frontloading may be needed to maintain access to markets and finance the deficit at reasonable rates—but, in general, a steady pace of adjustment is more important than front-loading, which could undermine the recovery and be reversed. Nonetheless, a non-trivial first installment is needed: promises of future action will not be enough.

Current fiscal consolidation plans in advanced G-20 countries imply on average a reduction in the cyclically adjusted deficit of some 1¼ percentage point of GDP in 2011, with significant dispersion around this according to country circumstances. This seems broadly adequate, and consistent with commandment I, at least based on current projections on the recovery of aggregate demand. This said, while front-loading fiscal tightening is, in general, inappropriate, front-loading the approval of policy measures (which would become effective at a later date) will enhance the credibility of the adjustment.

Commandment III: You shall target a long-term decline in the public debt-to-GDP ratio, not just its stabilization at post-crisis levels.

High public debt tends to raise interest rates, lower potential growth, and impede fiscal flexibility. Since the early 1970s, public debt in most advanced countries has been the ultimate absorber of negative shocks, going up in bad times, not coming down in good times. In the G-7 average, gross debt was 82 percent of GDP in 2007, a level never reached before without a major war. The current fiscal doldrums are due not only to the crisis, but also to how fiscal policy was mismanaged during the good times. This time, it must be different: the final goal must be to lower public debt ratios, gradually but steadily.

Commandment IV: You shall focus on fiscal consolidation tools that are conducive to strong potential growth.

This will require a bias towards (current) spending cuts, as spending ratios are high in advanced countries and require highly distortionary tax levels. Some cuts should be no brainers: for example, shifting from universal to targeted social transfers would involve significant savings, while protecting the poor. Containing public sector wages—which have risen faster than GDP in several advanced countries in the last decade—will be necessary.

This said, nothing should be ruled out. Countries with low revenue ratios and large adjustment needs—like the United States and Japan—will also have to act on the revenue side. Promising “no new taxes,” in all countries and circumstances, is unrealistic.

Commandment V: You shall pass early pension and health care reforms as current trends are unsustainable.

Increases in pension and health care spending represented over 80 percent of the increase in primary public spending to GDP ratio observed in the G-7 countries in the last decades. The net present value of future increases in health care and pension spending is more than ten times larger than the increase in public debt due to the crisis.

Any fiscal consolidation strategy must involve reforms in both these areas. This includes Europe, where official projections largely underestimate health care spending trends. Given the magnitude of the spending increases involved, early action in these areas will be much more conducive to increased credibility than fiscal front-loading. And will not risk undermining the recovery. Indeed, some measures in this area—while politically difficult—could have positive effects on both demand and supply (for example, committing to an increase in the retirement age over time).

Commandment VI: You shall be fair. To be sustainable over time, the fiscal adjustment should be equitable.

Equity has various dimensions, including maintaining an adequate social safety net and the provision of public services that allow a level playing field, regardless of conditions at birth. Fighting tax evasion is also a critical component to equity. For VAT, a tax that is relatively resilient to fraud, tax evasion averages about 15 percent of revenues in G-20 advanced countries. Evasion for other taxes is likely to be higher.

Strong growth has a staggering effect on public debt: a one percentage point increase in potential growth—assuming a tax ratio of 40 percent—lowers the debt ratio by 10 percentage points within 5 years and by 30 percentage points within 10 years, if the resulting higher revenues are saved. An acceleration of labor, product and financial market reforms will thus be critical.

In the current context of weak aggregate demand, reforms that increase investment are more desirable than reforms that increase saving. While both have positive long-run effects, investment friendly reforms increase demand and output in the short run, while saving friendly reforms do the opposite. A word of caution, though: the timing and magnitude of the effects of structural reforms on growth are uncertain: fiscal adjustment plans relying on faster growth would not be credible.

Commandment VIII: You shall strengthen your fiscal institutions.

Sustaining fiscal adjustment over time requires appropriate fiscal institutions. The current ones allowed a record public debt accumulation before the crisis. They are insufficient. This requires better fiscal rules, including in Europe; better budgetary processes, including in the United States, where, at least for Congress, the budget is essentially a one-year-at-a-time exercise; and better fiscal monitoring, including through independent fiscal agencies of the type recently created in the United Kingdom.

If fiscal policy is tightened, interest rates should not be raised as rapidly as in other phases of economic recovery. Calls for an early monetary policy tightening in advanced economies are misplaced.

Commandment X: You shall coordinate your policies with other countries.

In a number of advanced countries, the reduction in budget deficits must come with a reduction in current account deficits. Put another way, if the recovery is to be maintained, the initial adverse effects of fiscal consolidation on internal demand have to be offset by stronger external demand. But this implies that the opposite happens in the rest of the world.

In a number of emerging market economies, current account surpluses must be reduced, and these countries must shift from external to internal demand. The recent decisions taken by China are, in this respect, an important and welcome step. Policy coordination will also be important in some structural areas: for example, over the medium term, it will be critical to protect fiscal revenues from rising tax competition.

Obey these commandments, and chances are high that you will achieve fiscal consolidation and sustained growth.

18 Responses

[…] So – there we have it: four motivations for continued sharp fiscal retrenchment – none of which actually relate to the reason we were given for front-loaded fiscal retrenchment at the outset: that this austerity would cause the private sector to invest and grow. This was the myth of ‘expansionary austerity’. A myth, by the way, cleanly, neatly and tightly debunked in an essay/paper from the USA’s Center for Economic Policy Research (CEPR) published some 7 months ago. Here (PDF). Way back in 2010 Olivier Blanchard of the IMF clearly said ‘Commandment II: You shall not front-load your fiscal adjustment, unless financing needs require it’. That was in June 2010. […]

Reform is a priority for the advanced economies, as current trends are unsustainable -–see Commandment V -–and for many emerging and low-income economies that need “to improve coverage of health care.”

Slowing the surge in spending is the vital part of any budget fix. But the looming budget gap is so large that many finance experts say taxes must rise. Mr. Obama has called for higher taxes on households earning more than $250,000 a year. He also drew sharp criticism from Republicans when he said he was “agnostic” on whether his fiscal commission would consider broader-based tax hikes.

[…] pension reform is a priority for the advanced economies as current trends are unsustainable—see Commandment V—and for many emerging and low-income economies that need “to improve coverage of health and […]

Commandment V (Bias to spending cuts): Advanced economies with high government revenues, above all the Scandinavian countries, are in a much better fiscal position than countries with very low government revenues (U.S., U.K., Japan, Ireland, Spain). Thus, the solution for countries with high deficits are not spending cuts (in most cases government expenditures in these countries are already very low), but tax increases. In addition the negative multiplier effects of tax increases are smaller than the multipliers of reduced government revenues.

“Thou shall not arbitrarily discriminate against risk-taking more than what the market already does”… since by doing so you just increase the chances of creating the conditions that always lead to a financial crisis… namely the excessive investment or lending to what is perceived as having little risk.

We currently have financial regulators who want to nanny bungee jumpers while forgetting to remind the school children to be careful when crossing the streets even when the light is green.

While the authors do state in Commandment 10 that certain advanced countries need to reduce current account surpluses, Commandment II gives them an out that they are currently exploiting. They lamely explain that other countries can lift that burden from them while they continue to enjoy their surpluses and bleed jobs from the rest of the world, all in the name of preserving low borrowing costs. Is that a good trade off?

China is the only country explicitly mentioned as contributing to global imbalance, yet China’s surplus has declined substantially while others have increased.

The Commandents IV “shifting from universal to targeted social transfers”, implies that the workers paying into SSN and Medicare while saving for their own retirement are goint to learn that the government word has no value. This implies that the currency allegedly back by the faith of the government has no value.

Commandment VI: “You shall be fair.” This implies that those who pay for those who don’t apply themselves.

The creator of wealth in society and the productive workers whom drive job creation loose incentive to continue to strive. I already made my decision on just the rumors of the different actions the government is taking to be “fair”. I quit a fairly good paying job before I could draw a pension. The Corporation has not found the skilled job seeker to fill my position. Taxes from the open position and opportunity for efficiency are being losted. Now tell me what incentive I or anyone who saved and invested wisely has to work like a slave so the society looks fair. The term “Fair” has broad meaning to people depending if you are the beneficier and the provider..

Commandents IV and VI are going to be the most difficult to fruit. Is the government not only going to deny us benefits that we paid for many years but also steal our assets? For many years, I expected mean testing of the SSN and Medicare benefits. Stealing of assets that a person set asides for raining days and retirement will disrupt job creation and higher tax revenues even more. How far will IV and VI be pushed? That is the scary scene everyone faces.

[…] Olivier Blanchard and Carlo Cottarelli, at El-Erian’s alma mater, the IMF, have more specifics. Yes, they say, the US will have to raise taxes. And cut spending: Some cuts should be no brainers: for example, shifting from universal to targeted social transfers would involve significant savings, while protecting the poor. Containing public sector wages—which have risen faster than GDP in several advanced countries in the last decade—will be necessary. […]

[…] –10 Commandment for Fiscal Adjustment: Olivier Blanchard and Carlo Cottarelli present 10 Commandments for fiscal adjustments in advanced economies. “Fiscal adjustment is key to high private investment and long-term growth. It may also be key, at least in some countries, to avoiding disorderly financial market conditions, which would have a more immediate impact on growth, through effects on confidence and lending. But too much adjustment could also hamper growth, and this is not a trivial risk. How should fiscal strategies be designed to make them consistent with both short-term and long-term growth requirements? We offer ten commandments to make this possible. Put simply, what advanced countries need is clarity of intent, an appropriate calibration of fiscal targets, and adequate structural reforms. With a little help from monetary policy, and from their (emerging market) friends.” […]